How does substitution affect elasticity

Consumers make their choices based on their overall spending power and make constant adjustments based on price changes. They strive to maintain their living standards despite price fluctuations. The substitution effect kicks in when a product's price increases but the consumer's spending power stays the same.

The substitution effect is strongest for products that are close substitutes. For instance, a shopper might pick a synthetic shirt when the pure cotton brand seems too pricey.

Eventually, enough shoppers may follow suit to make a measurable effect on the sales of both shirt makers. Elsewhere, if a golf club hikes its fees, some members might quit. However, if there is no comparable choice for them to turn to then they may just have to pay up to avoid quitting the sport completely. As illogical as it seems, the substitution effect may not occur when the products that increase in price are inferior in quality. In fact, an inferior product that rises in price may actually enjoy a sales increase.

Products that display this phenomenon are called Giffen goods , after a Victorian economist who first observed it. Sir Robert Giffen noted that cheap staples such as potatoes will be purchased in greater quantities if their prices rise.

He concluded that people on extremely limited budgets are forced to buy even more potatoes because their increasing price places other higher-quality staples altogether out of their reach. Substitute goods may be adequate replacements or inferior goods. Demand for an inferior good will increase when overall consumer spending power falls. Small Business. Behavioral Economics. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. That means, when the price of an item rises slightly, consumers will switch to its substitute. Consider two soap products with different brands. Both offer the same quality.

A decrease in price in one brand encourages you to buy it. In contrast, a price increase encourages you to purchase an alternative brand. Likewise, with Pepsi and Coca Cola. An increase in Coca Cola prices encourages you to prefer Pepsi, and the opposite effect applies when Coca Cola prices go down.

Furthermore, when there is little or no good substitute for an item, demand is inelastic. Consumers will continue to buy products even if prices rise because they have no alternative. Consider the cancer drugs you take while you are on treatment. Also, you are not likely to increase purchases even if prices fall. Select personalised content.

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Microeconomics Concepts. Key Takeaways Many factors determine the demand elasticity for a product, including price levels, the type of product or service, income levels, and the availability of any potential substitutes. High-priced products often are highly elastic because, if prices fall, consumers are likely to buy at a lower price.

Compared to essential goods, luxury items are highly elastic. Goods with many alternatives or competitors are elastic because, as the price of the good rises, consumers shift purchases to substitute items.